Ownership Cost: Homeowners Associations

Four Major Variables that Determine Market Price

Over the last three days we looked at the four main variables that determine home price:

borrower income,

allowable debt-to-income ratios,

interest rates, and

downpayment requirements.

Today we are looking at homeowners associations because this expense (1) reduces your payment to the lender, (2) reduces the amount you can borrow and bid, and thereby (3) reduces the value of real estate. People can persuasively argue that HOAs add more value than they cost, and I believe this is true, but that value is reflected in market comps. When you examine the details of cashflow, HOAs are a cost, nothing more.

Avoiding the toxic condo association

As the housing crisis continues, some condo associations can be dominos lined up to fall.

This is not to say that you should avoid any property with a Homeowners Association, and in large swathes of Orange County, it’s very hard to have a property that doesn’t have an HOA. As a best example, let’s look at my large scale HOA in Fountain Valley. This is a master recreation association which maintains 20 acres of parks, three pools, and some buildings in a forty year old neighborhood with 1,048 homes. The association runs a swim team, picnics, kids’ events at holidays, and doesn’t get involved in telling people what color to paint their homes. The city maintains the streets, street lighting, sweeps the streets, writes parking tickets, and has code enforcement officers to keep properties maintained.

Properties don’t turn over very quickly here, but we’re still seeing the results of the borrowing binge. Our assessments over 90 days past due have tripled in the last year, and the money we will write off as uncollectible could be in the $10,000 range next year, versus less than $1,000 last year. It doesn’t make the directors happy, but our budget is over $750,000 a year, our capital reserves are fully funded at close to $500,000 and we have operating funds in the bank of over 100,000.

So a ten-fold increase in uncollectible assessments is a blip on our balance sheet. A couple more years like this and we might have to raise assessments another dollar or two a quarter.

Los Condos Diablo

Let’s take the reverse of this scenario, with a condo association somewhere in South County we’ll call Los Condos Diablo. It’s a 200 unit association where everything is a common asset – not just the land, but the sidewalks, streets, street lights, the roofs and walls of every building, the trash enclosures, stairways, patios and decks.

Builders threw the place up quickly and there have been serious ongoing maintenance problems which have been handled with band-aid type repairs. The board of directors has been very reluctant to raise assessments, so the reserves are funded at around 20% . Emergency safety repairs, collapsing stairways, remediating mold problems from roof leaks, and other expensive problems keep preventing them from catching up on maintenance. Exterior second story decks that should have had a new surface coating, new paint and gutters now needs to be torn down and completely rebuilt.

So instead of being like my HOA, where we are current on all of our maintenance and have $600 in the bank for each homeowner, Los Condos Diablo has net deferred maintenance liabilities of $5,000 a unit, and is struggling to pay their bills every month. Because so many structural elements have been compromised, to bring this set of buildings to good condition would take over a million in reconstruction, money they don’t have and can’t save or borrow.

And here’s the kicker for that condo association. They were upside down on their maintenance before people started defaulting on their loans, and people are defaulting like crazy. These were entry level condos, and when prices started rising, lots of folks cashed out and moved up. Over half the units turned over close to the peak, and probably two thirds of them are underwater.

When someone loses a job or just gives up, they stop paying their HOA fees. The HOA starts adding penalties, filing liens, sending notices, and running up legal costs. Ultimately, some day, the bank forecloses and the property changes hands. At that point all of the past due assessments get written off. The bank is only responsible for paying from the date they assume title. Worst of all, a management firm or collection firm might now be owed late fees and legal fees that were assessed.

With assessments of $250 per month past due for 18 months, plus another $500 in fees the condo association is out $5,000 that they need to collect somehow from the rest of the owners. If ten percent of the 200 units go belly up, the remaining 180 owners each now has another $555.00 apiece in debt that they share with the remaining owners.

Now let’s add another kicker. The Directors of the Condo Association, volunteers who have stepped up out of civic duty, see all of this coming and can see it getting worse and worse. Their neighbors rise up in anger when they try to raise assessments, cursing and threatening recall. Instead of continuing to take abuse from their neighbors, they resign or sell out and move on, leaving the community without a board of directors. The management company tries to hold a new election, and nobody volunteers. They send a letter to all the owners, resigning their contract.

So the State Department of Real Estate ….. Oh wait, there isn’t any agency with responsibility to pick up the slack for a failed condo association. What happens next is anybody’s guess, but it will most likely involve lawyers and the Superior Court, adding another layer of debt to each owner.

So if you think you’re getting a bargain in a low-end bank owned condo, you might in fact also be buying a big liability that you will have to pay for somewhere down the line.

Never, ever make an offer on a condo without getting a copy of the last year’s budget, and seeing the state mandated disclosure from the reserve study. If you can’t get it, walk away. WALK AWAY, and if an agent tells you it’s not important, he’s either a fool or a scoundrel.

Reserve Studies

A reserve study is a document that is updated every year as required by state law. It’s fairly complex, yet also pretty simple.

We know that woodwork on buildings needs to be painted every four years and stucco every eight years. We know the pool needs re-plastering every twelve years. We know that the life on the flat roof is around fifteen years, and that the playground equipment should be replaced after every fifteen years. So an analyst assigns a cost and a life to each major component of an association. Then they figure out how much the association should be saving for each component, and plug it all into a big spreadsheet. That shows how much should be available every year for major maintenance and replacement items, and how much the association should be setting aside so that money is available. The idea is that the level of assessments remains very stable as long as the association doesn’t have to pay for several major components all at once from their monthly assessments.

There’s a big catch. The state requires that you do a study, disclose the results, and have a plan if there’s a deficiency, but the association doesn’t actually have to appropriate the money, and most fall short.

So a smart buyer has to look at the summary of the reserve study has to be mailed with the budget, and the calculation that is required by state law.

Here’s what it looks like for a fully-funded reserve from my own association.

Based on the method of calculation in paragraph (4) of subdivision (b) of Section 1365.2.5, the estimated amount required in the reserve fund at the end of the current year is 452,933 based in whole or in part on the last reserve study or update prepared by Advance Reserve Solutions, Inc. as of January 1,2008. The projected reserve fund cash balance at the end of the current fiscal year is $433,225, resulting in reserves being 96% funded at this date, The current deficiency in the reserve fund represents $18.81 per ownership unit.

This is a source of pride. For every one of the 1048 units, there is $413.38 in funds dedicated to replace everything. That money is set aside in separate accounts that can’t be used for operating expenses, and there’s an annual contribution to maintain the counts at close to the ideal level.

Let’s say you have another association, where the association hasn’t funded their reserves. That line might show reserves funded at 50% and a deficiency in the reserve fund of $1153.41 per unit. Is that bad? Not necessarily. But you better budget for your HOA assessments to increase by 20% per year, which is the maximum allowed by state law without a vote of the members.

Although it’s improbable, even an association with reserves funded at 10% might be financially solid if they have just completed re-roofing every building and replacing every piece of deteriorating wood work.

Where does the red flag go up, where you should just steer clear of a condo?

As a rule of thumb, less is more, but bigger is better. The fewer parts of the individual units that are maintained by the association, the less likely you are to face significant issues from underfunded reserves and deferred maintenance. And also, the larger the association, the more likely you are to have professional management, and the more units you have to divide fixed annual costs like the corporation filing fees, d&o insurance policy, cost of the reserve study, et cetera.

Before you start looking, find a real estate agent to represent you who understands what you’re talking about, and knows that you’re going to need a copy of the last budget before you make an offer. Just as there are HOA’s where you’re actually getting a valuable share in cash assets as part of your purchase, there are professionals out there who will help you gather the information you need to make a good decision.

Then use some common sense and use your eyes.

Look at the numbers in the budget and the reserve study. How long would it take the association to catch up on under-funded reserves? How much is the deficit in relation to the value of the unit and the current monthly payment? Underfunded reserves are frequently associated with dysfunctional condo politics, deferred maintenance and serious rates of delinquencies. Politics? Yes, some associations have repeated recall elections, with warring factions wasting money on attorneys while their finances fail, or they have idiots elected to their boards who are more interested in the neighbor’s dogs than preserving and protecting assets.

So if the numbers don’t look good, they may in fact be far, far worse.

Also, look for signs of deferred maintenance – rust on wrought iron fences, peeling paint and dry rot, missing roof tiles, cracks in asphalt are the most obvious, but with a sharp eye you can look at the edges where the decks meet stucco, where the eaves meet the roof and see if these most vulnerable areas look as if they’re tightly sealed and well-maintained.

Whatever you do, steer clear of Los Condos Diablos, the nightmare association where everything is going wrong. At its worst, it’s broke, internally at war, and unable to find a way out of the hole that its owners have been excavating for years. Every dollar you put into a part of a failing condo association is at risk.

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HOA Analysis Service

The author of today’s post has been in contact with me via email for quite some time. He is contemplating offering HOA analysis as a service, and I told him it is a great idea. IMO, getting an HOA analysis is just as important as getting a home inspection.

Both HOA analysis and home inspection are insurance against unknown expenses you may face in the future if you acquire property. A cracked foundation can cost you tens of thousands of dollars — an underfunded HOA can cost you even more. Both are equally important.

Unfortunately, to my knowledge, nobody is providing HOA analysis as a service. The documents are hard to get (HOAs are not keen to display their dirty laundry), and the initial review is time consuming, but such a service would cost no more than a home inspection, and perhaps even less.

In a post-Great Housing Bubble era, we will see a financial wasteland on HOA balance sheets. Many have always been underfunded, but even strong HOAs will suffer when the payments stop coming. Most readers of the Irvine Housing Blog will buy in a community with an HOA. Without this service, it will be a crapshoot whether or not you find a stable and well-funded HOA.

If any readers care to comment on whether or not you consider this service to be valuable, perhaps we can convince the author to offer this service to everyone. I think it would be great.